Title LM03 Derivative Benefits, Risks, and Issuer and Investor Uses IFT Notes.pdf ✅

LM03 Derivative Benefits, Risks, and Issuer and Investor Uses 2025 Level I Notes © IFT. All rights reserved 1 LM03 Derivative Benefits, Risks, and Issuer and Investor Uses 1. Introduction ........................................................................................................................................................... 2 2. Derivative Benefits .............................................................................................................................................. 2 3. Derivative Risks.................................................................................................................................................... 4 4. Issuer Use of Derivatives .................................................................................................................................. 5 5. Investor Use of Derivatives .............................................................................................................................. 6 Summary ...................................................................................................................................................................... 6 Required disclaimer: IFT is a CFA Institute Prep Provider. Only CFA Institute Prep Providers are permitted to make use of CFA Institute copyrighted materials which are the building blocks of the exam. We are also required to create / use updated materials every year and this is validated by CFA Institute. Our products and services substantially cover the relevant curriculum and exam and this is validated by CFA Institute. In our advertising, any statement about the numbers of questions in our products and services relates to unique, original, proprietary questions. CFA Institute Prep Providers are forbidden from including CFA Institute official mock exam questions or any questions other than the end of reading questions within their products and services. CFA Institute does not endorse, promote, review or warrant the accuracy or quality of the product and services offered by IFT. CFA Institute®, CFA® and “Chartered Financial Analyst®” are trademarks owned by CFA Institute. © Copyright CFA Institute Version 1.0
LM03 Derivative Benefits, Risks, and Issuer and Investor Uses 2025 Level I Notes © IFT. All rights reserved 2 1. Introduction This learning module covers:  The benefits and risks of using derivatives  A comparison of how issuers use derivatives versus how investors use derivatives 2. Derivative Benefits Some of the benefits of derivatives are listed below: Risk Allocation, Transfer, and Management Derivative instruments enable users to allocate, transfer, and/or manage risk without trading an underlying. In many scenarios, issuers and investors face a timing difference between making an economic decision and being able to transact in a cash market. The curriculum provides the following examples: Issuers:  A manufacturer may need to order commodity inputs for its production process in advance of receiving finished-goods orders.  A retailer may await a shipment of goods priced in a foreign currency before selling domestic currency to make payment.  An issuer may wish to lock in its future debt costs in advance of the maturity of an outstanding debt issuance. Investors:  An investor may seek to capitalize on a market view but lack the necessary cash on hand to transact in the spot market.  In anticipation of a future stock dividend, debt coupon, or principal repayment, an investor may decide today how it will reinvest the proceeds in the future. In such scenarios, derivatives can be used to lock in a pre-agreed price for a future date and bridge the timing gap. For example, if an investor has a bullish view on the market but lacks the cash to transact in the spot market, he can purchase a forward contract or a call option on an index to benefit from his view. Derivatives allow users to create exposure profiles which are unavailable in cash markets. For example, a short call position can be added to an existing long cash position to create a ‘covered call’ position. A covered call generates a higher return as compared to the original long cash position if the underlying price is stable or slightly higher. Instructor’s Note: This concept is covered in a later learning module.
LM03 Derivative Benefits, Risks, and Issuer and Investor Uses 2025 Level I Notes © IFT. All rights reserved 3 Information Discovery There are two primary advantages of futures markets:  Price discovery: Market participants often use futures prices to forecast the direction of cash markets. For example, analysts frequently use interest rate futures markets to gauge investor expectations of a central bank's benchmark interest rate increase or decrease at a future meeting.  Implied volatility: Implied volatility measures the expected risk of the underlying. With the models such as BSM to price an option, it is possible to determine the implied volatility, and hence the risk. Instructor’s Note: This concept is covered in a later learning module. Operational Advantages Some of the major operational advantages associated with derivatives are given below:  Lower transaction costs than the underlying.  Greater liquidity than the underlying spot markets.  Margin requirements and option premiums are low relative to the cost of the underlying  Easy to take a short position. Market Efficiency Derivatives markets offer a less costly way to exploit mispricings in the market due to operational advantages: low transaction costs, easier to take a short position, etc. Therefore, any mispricing is corrected more quickly in the derivatives market than the spot market. Thus, the existence of derivative markets causes financial markets in general to function more efficiently. Exhibit 1 from the curriculum summarizes the benefits of derivative instruments. Purpose Description Risk Allocation, Transfer, and Management Allocate, trade, and/or manage underlying exposure without trading the underlying Create exposures unavailable in cash markets Information Discovery Deliver expected price in the future as well as expected risk of underlying Operational Advantages Reduced cash outlay, lower transaction costs versus the underlying, increased liquidity and ability to “short” Market Efficiency Less costly to exploit arbitrage opportunities or mispricing
LM03 Derivative Benefits, Risks, and Issuer and Investor Uses 2025 Level I Notes © IFT. All rights reserved 4 3. Derivative Risks The main risks associated with derivatives are listed below: Greater Potential for Speculative Use Derivatives have a high degree of implicit leverage as compared to a similar cash position. This magnifies profits/losses and increases the likelihood of financial distress. Lack of Transparency Derivatives increase a portfolio’s complexity. They may create an exposure profile that is not well understood by stakeholders. This risk increases when a combination of derivatives and/or embedded derivatives is used. For example, structured notes are a broad category of securities that combine features of debt instruments with embedded derivatives designed to achieve a particular issuer or investor objective. They often involve greater cost, lower liquidity, and less transparency as compared to an equivalent stand-alone instrument. Basis Risk Derivatives are often used to hedge the risk of a commercial or financial exposure. The assumption here is that the derivative instrument will be highly effective in offsetting the price risk of the underlying. However, in some cases, the expected value of a derivative differs unexpectedly from the underlying. This is referred to as ‘basis risk’. Basis risk can occur when a derivative instrument refers to a price or index that is similar to, but does not exactly match, an underlying exposure. Liquidity Risk Liquidity risk refers to the divergence in cash flow timing of a derivative versus that of an underlying transaction. For example, future contracts require daily settlement of gains and losses and can give rise to liquidity risk. An investor using futures to hedge an underlying transaction may be unable to meet a margin call due to lack of funds, and may be forced to close out his position. Counterparty Credit Risk Derivatives can result in significant counterparty credit exposure. Unlike bond markets where credit exposures are easy to predict based on the notional principal and accrued interest; predicting the credit exposures of derivatives is more challenging. Credit exposures vary based on the type of derivatives. For example, a call option seller has no counterparty credit risk exposure after receiving the premium, but a call option buyer is exposed to counterparty credit risk, which varies depending on the price of the underlying. Destabilization and Systemic Risk